What are NFTs, and how do they work?

What are NFTs, and how do they work?

Published January 4, 2023

9 min read

In recent years, a new digital file format has promised to revolutionize how things can be owned, bought, and sold across the internet: the “non-fungible token,” or NFT for short. Artists and publishers are now exploring the NFT technology.

Want more information about NFTs? We’ve got you covered.

What are NFTs?

To understand NFTs, it’s useful to understand their underlying technology: the blockchain.

Blockchains are computer protocols designed to get many computers to agree on the same sequence of transactions without trusting each other. Blockchains use economic incentives and cryptography instead of third parties to verify transactions. This makes falsifying transactions expensive and easy to spot. This arrangement allows computer networks to maintain databases in a public, redundant, and decentralized manner.

Blockchains’ exhaustive record-keeping means that apps built atop them can create snippets of code that can be tracked as distinct entities and transferred from user to user. These “tokens” are non-fungible, meaning that they cannot be swapped for another.

The idea behind NFTs is to create scarcity for digital items, which allows for a new type of traceable digital ownership. A digital asset such as an image or a video could appear many times on the internet. However, only a few instances (or even one) would have the NFT provenance. (The Walt Disney Company, majority owner of National Geographic Media, sells NFTs. National Geographic Media has partnered with the NFT platform Snowcrash to do the same. )

Importantly, NFTs don’t necessarily hold the data for the asset itself (though some do), nor do they necessarily transfer copyright. Most often, an NFT includes a URL linking to the asset. This URL is stored on a separate computer network. Over the past two decades, NFTs have attracted a lot of attention because of the large amounts of money they have attracted. These NFTs are used as collectibles as well as speculative investments and displays of wealth. In March 2021, the digital artist Beeple sold an NFT for $69 million at auction to an investment firm seeking to promote digital art. The Bored Ape Yacht Club, an NFT collection depicting a series of 10,000 cartoon primates, skyrocketed in value in early 2022 after a string of celebrity promotions. These NFTs now sell for tens of thousands of dollars.

By the end of 2022, the year’s NFT sales had totaled more than $11 billion–but over that span, the market was extremely volatile. Measured in dollars, the sales volume for the NFT marketplace OpenSea fell by more than 95 percent from January 2022 to November 2022, according to data compiled by the firm Dune Analytics. The broader market for NFTs and the related assets known as cryptocurrencies (digital “coins” that blockchains make scarce and therefore tradeable) hemorrhaged $2 trillion in July 2022 after soaring to $3 trillion eight months earlier.

How could NFTs be used?

Proponents argue that NFTs provide a new revenue model for artists by letting them sell pictures, videos, and other digital assets as online collectibles or fine art. They also can act as fundraising tools, with Ukraine raising tens of millions of dollars in NFT auctions last year to support its war effort against Russia.

Unlike standard digital files, NFTs can contain tiny computer programs called “smart contracts,” which sometimes can issue royalties to an NFT’s original artist when the NFT is resold. Because NFTs are unique and transferable, they also can function as tickets, membership credentials, or even records for carbon credits. Blockchain-based video games, such as Axie Infinity, use NFTs as in-game characters and items that players can own (and even pay other players to earn).

Some artists hope that NFTs–and the art scene they’ve created–can shake up the creative industries’ traditional business models, giving artists more lucrative and equitable opportunities. Already, artists are using NFTs to help organize collectives of fans and patrons called decentralized autonomous organizations, or DAOs for short (rhymes with “wows”).

At their most bullish, NFT advocates argue that the technology could underpin people’s identities within a “metaverse.” According to this vision, people will use virtual “avatars” to work and play within many interoperable digital spaces. Just as we own unique items in the real world, proponents imagine that NFTs would act as deeds for the metaverse’s equivalents.

Beyond digital ownership, NFTs’ decentralized nature means that they could be used to help protect digital files against tampering or to track files’ chain of custody. In June, Starling Lab, a research group co-founded by Stanford and the USC Shoah Foundation, submitted a dossier to the International Criminal Court that used NFTs and related technologies to archive records of Russian military attacks on Ukrainian schools.

What are some of the criticisms against NFTs?

Just as NFTs have attracted an ardent community of supporters, they also have drawn considerable criticism.

Many of the proposed uses for NFTs don’t require them to work (e.g. club memberships), or have not been realized yet. As a result, some critics see NFTs’ proliferation as nothing more than a “gold rush” that has little to do with the underlying technology.

There are also technical concerns. Whether one of NFTs’ most bullish use cases, an interoperable “metaverse,” is even technically feasible is a matter of debate. If you’ve ever clicked on broken links, you know how difficult it is to keep digital assets online. NFTs don’t usually contain digital assets. Therefore, an NFT can only be as stable and reliable as the computer or network that stores the asset’s files. Even if the computer storing the asset is properly maintained, it’s hard to prevent “bit rot,” or data’s tendency to degrade over time. In response, developers are devising ways to store files in a decentralized, redundant format.

Like other fledgling technologies, NFTs also have lured in plenty of bad actors. Grifters have inflated NFTs’ prices via self-dealing “gold brick” scams and have minted and sold scads of NFTs based on stolen art. NFT projects appear with alarming regularity. They promise buyers a long-term vision and then shut down and steal the buyers’ money. The scheme is so common, there’s a term for it: “rug-pulling.”

Scammers have had some help from the blockchain itself. NFT thieves regularly use phishing attacks and other methods to trick people into emptying out their digital wallets. In 2022 alone, more than $100 million worth of NFTs were stolen. But because NFT transactions are decentralized by design, illicit transfers can’t be reversed by a third party.

NFTs have been criticised for their carbon footprint. The Ethereum blockchain is a major energy hog. On one day in January 2022, for example, one Ethereum emissions estimate exceeded 300 pounds of CO2 for an average transaction. That’s like setting more than 16 gallons of gasoline ablaze.

In September 2022, however, Ethereum switched to a “proof of stake” architecture, which reduced its energy use and CO2 emissions by more than 99.9 percent. The Crypto Carbon Ratings Institute, a German analytics firm, estimates that the electricity for one Ethereum transaction now shakes out to 0. 0063 kilowatt-hours–or roughly 3 grams of CO2, the emissions of driving the average U.S. passenger vehicle about 40 feet.

While NFTs’ energy use has come down dramatically, NFTs are a key on-ramp for many people into the broader “crypto” space. By itself, the best-known blockchain Bitcoin leads to millions of tons of CO2 and thousands of tons of electronic waste each year.

What’s the future of NFTs?

Currently, NFTs find themselves snowed in during a “crypto winter,” a deeply skeptical cryptocurrency market that’s cooled off from the highs of early 2022. After billions of dollars’ worth of losses and theft, and the collapse of some of cryptocurrencies’ biggest companies, regulators around the world are working through how to classify and tax the assets. Yet, NFTs have remained. Perhaps like the dot-com crash of the early 2000s, many NFT startups will wither away under the market’s intense scrutiny–and the few that survive will remake the digital world.

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